The short answer is yes, taxes matter in divorce property division. In family law cases, property is valued at fair market value. The simplest definition of fair market value is the amount of cash one receives if the property is sold or transferred to an unrelated party. The underlying questions we need to ask is, “What is the tax cost associated with turning this asset into cash?” or “Does this liability entitle the borrower to a tax deduction?” All dollars are not created equal under the tax code!
Let’s look at the example of a retirement account, such as a traditional 401(k) account. We’ll assume no Roth contributions for simplicity. The dollars contributed by the employee spouse and by the employer for any matching contributions are not subject to federal income tax for the employee spouse at the time the contribution is made. The account is allowed to grow without any federal income tax due on the earnings. But Uncle Sam doesn’t give freebies. When cash is distributed from the 401(k) account to the employee (or the non-employee spouse, if the account is divided), that cash is taxed to the account owner in the year of distribution. If the account owner has not yet reached age 59 ½ or does not meet any of the other special rules for early disbursements, the cash is also subject to a 10% penalty.
For example, Mary (age 56) and Sam (age 60) have a savings account and a traditional 401(k) account which each has a $50,000 balance. Do they have the same value? No. If Mary becomes the 401(k) owner and wants the cash disbursed to buy a car and pay debts, she will pay a $5,000 penalty. If she is in the 22% federal income tax bracket, she will also owe $11,000 in federal income tax on the distribution. Thus, the actual cash available to her to spend would be $34,000, while Sam, as the owner of the savings account has $50,000.
In the same scenario, Sam would not incur the penalty were he the 401(k) owner because of his age. If his tax bracket was also 22%, he would net $39,000 in after-tax cash.
There are many other assets that have tax attributes that should be considered in dividing marital property. The marital residence, investment accounts, rental real estate, and businesses are a few examples of assets that could be subject to federal taxation when sold or liquidated. Mortgage and student loan interest may provide the borrower with a deduction for federal income tax purposes. IRS Publication 504 gives more information about the tax attributes of property in divorce.
Let us help you make tax-savvy decisions in your divorce. Call (615) 507-2093 or email firstname.lastname@example.org to schedule a consultation.